State of the Economy: Analyzing Micro and Macro Forces

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 |  Includes: AGG, DIA, GE, GOOG, QQQ, SPY
by: Dhinesh Ganapathiappan

The S&P 500 is now down over 10% in a matter of weeks and there is no shortage of fear and volatility in the market. Where do we stand now and just how bad is the economy today? Let’s dig deeper into the factors at play and what the future may hold by examining the link between micro and macro forces.

The average consumer is in a state of flux, having experienced the aftermath of the 2000 tech bubble and 2008 financial crisis. Unemployment is officially at 9%, but including discouraged workers that have given up their searches; the true unemployment rate soars to 16%. Workers out of jobs leave fewer consumers with disposable incomes to spend and unsurprisingly consumers have been cutting back on spending and save more than ever before. Many have lost their homes to foreclosure, jobs to the recession and a big chunk of their net worth to the housing and stock market crashes.

The uncertainty that consumers face has led to lower levels of household creation and home buying. Household creation is a key driver in generating growth as it leads to more spending as newly formed families purchase house’s, big ticket items and have children. Instead, more Americans are choosing to rent, or in the case of new college graduates, live at home with parents. Population growth is coming off the slowest decade of growth since the Great Depression and projected to grow by just 13% from 2010 to 2025 according to the Population Reference Bureau. Against this backdrop, consumer confidence is at the lowest in a year and even sentiment among high income consumers has dropped by 33% from February to July.

Corporations are facing a similar state of uncertainty as there is not enough clarity on possible taxation reform and the global growth outlook. Having been through the post-2008 freeze in credit they are raising and holding onto cash to weather any more storms that come up. In fact, the 30 Dow companies increased their cash and short term securities by 18% from the year earlier according to a MarketWatch and FactSet Research review. Very little of this capital is going towards expansion or research and development, traditional drivers of growth. Companies have been getting leaner the last few years with cost-cutting to grow earnings during a time that revenue growth was hard to come by. Those trends are continuing as business process outsourcing and optimization takes full effect. The incentives and rationale for hiring abroad often makes more sense than adding workers domestically.

On that tax front, companies are taking advantage of loopholes to minimize their liabilities as much as possible within legal bounds. A few of the higher profile companies engaging in this include Google (NASDAQ:GOOG) and General Electric (NYSE:GE). Google funnels its income through low-tax regions of the world including Ireland, the Netherlands and Bermuda. This scheme cut Google’s overseas tax rate to just 2.4%. Often times the subsidiaries in these regions are unstaffed and set up for the sole purpose of transfer pricing. General Electric also saves billions of dollars by leaving their profits offshore and deferring payment on those profits. In fact, GE paid zero taxes in 2010 and 2009. Domestically, there have been calls for tax reform but a quick consensus remains unlikely given the latest fiasco to raise the debt ceiling.

Additionally, there is a shift in hiring practices by companies. Previously, companies would keep staffing at levels that could absorb additional growth. Now, companies are squeezing more productivity out of existing employees and looking to part time, temporary and contingent workers more than ever. These strategies offer flexibility to instantly respond to demand shifts and avoid paying for traditional employee benefits. This is great from the company perspective, but can be partially blamed for persistent unemployment and under-employment.

On the government side, the last decade has seen great debt-fueled spending and stimulus at the first sign of distress. At some point, the economy will need to be left to its own market forces and find equilibrium. That time appears to be coming sooner than later with the Standard and Poors downgrade of U.S. credit rating and the necessity to curb the deficits and outstanding debt. Government spending currently comprises about 40% of U.S. GDP and that figure will have to come down as the $14.6 trillion national debt is addressed. The high unemployment rate strains on two fronts – government spending for unemployment benefits and less tax revenue. Extending unemployment benefits beyond the already extended 99 weeks is a temporary (and costly) solution that doesn’t address the underlying lack of hiring. There is also an overhang of what the future holds for Medicare, Medicaid and Social Security. Thus far, the government has been quick to bail out and save those it deemed too big to fail, but the moral hazard the banks, insurers and automakers got away with is less likely to be repeated as more scrutiny falls on government actions.

Furthermore, the Federal Reserve is running out of options to stimulate growth and hiring. The announcement to maintain low rates through mid-2013 is troublesome because it doesn’t go far enough and risks sending the United States further on the path Japan took in the 1980’s and 90’s. The parallels are shocking – a debt fueled real estate bubble that overheated and collapsed from speculation and leverage, intervention and bailouts by the government, low interest rates and a government spending binge to prop up the economy, creating huge budget deficits. The result for Japan was deflation and stagnant economic growth. Today Japan’s debt-to-GDP ratio stands at 195%, one of the highest in the world. A potential QE3 to purchase more bonds and inject liquidity into the market will not be enough as the short-lived effects of QE2 and already rock bottom interest rates have shown. The Fed will need to find a new tool to stimulate the economy.

Another region of the world facing major headwinds is Europe, where debt-to-GDP ratios are rivaling the United Status. While the U.S. is at 79%, the U.K. is at 81%, Italy at 119%, France at 86%, with a similar picture throughout the eurozone. In contrast, Australia stands at 27%, China at 17% and Mexico at 42% in an increasingly competitive global economy. The European debt crisis comes from concerns that European countries will be unable to pay rising interest costs on their ballooning debt as economic growth in weak. Being tied to the euro currency and European Central Bank leaves little flexibility for individual countries to influence policy. This year the ECB has raised interest rates twice to deter inflation, but higher rates mean higher borrowing costs for government debt and a stronger currency, which reduces exports. The problems facing European countries is similar to what banks faced in the 2008 financial crisis – and there is potential for a similar escalation of contagion if a country does default and the implications for other countries, banks and companies are not clear. The ECB has a huge task on its hands managing and balancing its monetary policy for 17 precarious nations.

Overall, this vicious cycle facing consumers, corporation and government is the structural problem facing the global economy today. At this time there doesn’t appear to be a catalyst to pull U.S. out of the downward path as uncertainty and geopolitical risk reigns and we are weaned off stimuli that produced artificial growth. After the recent sell-off in stocks, valuations are getting cheap, but the longer term picture is unclear.

Opportunities exist internationally, namely the larger and better capitalized emerging markets in Southeast Asia that are pumping out consistent GDP growth and appear to be on firmer footing into the future. Something new will have to happen to stem the fundamental shift of capital and power to these regions as they chip away at the United States crown as the world’s economic superpower. For now, the “new normal” can be expected to continue in the short term and may quickly become the “normal.”

Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.